As expected, the plan would create three individual income brackets — 10 percent, 25 percent and 35 percent — and would tax a portion of muni bond interest, which is currently tax-exempt, for those in the highest bracket. The surtax would apply to individuals with incomes of $400,000 or more and couples with $450,000 or more of income as well as all munis they hold, whether new or outstanding.

It would essentially cap at 25 percent the value of tax exemption for those in the 35 percent tax bracket, sources said. The surtax would be unprecedented and would likely dampen demand for muni bonds and raise borrowing costs for state and local governments, market participants said.

Camp’s proposal singles out high earners, above $400,000 for an individual and $450,000 for couples, to tax their municipal interest at 10 percent. I pulled the most recent IRS data and there were about 432,000 taxpayers with incomes above $500,000 who filed returns in 2011 and claimed tax exempt interest ($500,000 is the closest income break in the IRS tables). Their total non-taxed municipal interest was $25.56 billion for 2011 or an average of $59,000 per taxpayer. At the very top of the table 9,186 taxpayers earned $4.2 billion tax exempt interest or $458,000 for each taxpayer. Interestingly, in the highest income brackets the number of taxpayers collecting tax-exempt interest and taxable ordinary dividend income are roughly the same (see chart):

There were 5.4 million tax returns that claimed municipal tax exemption that fell below the income level that Camp wants to tax with gross municipal interest income of $44.4 billion (average $8,200 per taxpayer). In contrast, there were about 26.3 million tax returns below $500,000 that claimed ordinary dividends of $112.4 billion (average of $4,200 per taxpayer), which the Camp plan wants to tax at 24.8 percent.

I’ve always wondered if a cap for the municipal interest exemption for the richest Americans would push distribution down to lower-income Americans who often have a difficult time getting access to municipal bond primary offerings. It seems as if there is a large untapped pool of demand for municipal bonds in lower tax brackets.

President Obama and many in Congress seem intent on taxing municipal interest for the wealthy. The million dollar question is whether this will create access to muni bonds for less affluent taxpayers or raise the yields that state and local governments pay to borrow. Unfortunately there is no way to test tax changes before they are implemented.

Author Profile

I’m Cate Long and I write about the retail fixed income markets including municipal bonds. My primary interest is creating tools and systems to help retail investors understand bond markets. I’ve worked for a number of years with industry standards organizations, regulators and Congress to help craft a more transparent and fair framework for investors to participate in the fixed income markets. I'm a guest contributor to Reuters.com. Any opinions expressed are mine alone.